The Slovak Republic enjoyed one of the strongest recoveries in Europe, reflecting its sound economic foundations and prudent policies, but the economic outlook is uncertain due to spillovers from the euro area crisis, the IMF said in its annual health check of the economy.

Amid a worsened external environment and despite a sizable fiscal consolidation, real GDP growth expanded by 3.3 percent in 2011. In 2012, growth is expected to slow to 2.6 percent, the report said.

The government made a significant deficit reduction in 2011 and plans additional cuts in 2012. In addition, Slovakia’s banking system is liquid, well-capitalized, and is mostly funded by relatively stable domestic deposits.

Outlook faces risks

As the external environment strengthens, growth is expected to pick up to about 3½ percent over the medium term. However, this positive outlook faces considerable downside risks.

Externally, an intensification of the euro area crisis would reduce demand for Slovak exports and increase funding cost, lowering growth and weakening banks’ balance sheets. Although the largely foreign-owned banking system is mostly funded by domestic deposits, it remains exposed to risks stemming from potential renewed stress in Europe if the economy weakens and parent banks come under pressure.

Domestically, a loss of market confidence in the government’s commitment to reduction of the fiscal deficit would increase funding costs and result in tighter credit conditions with negative knock-on effects on growth.

Policy priorities

According to the IMF’s assessment, policies should focus on mitigating risks and promoting a strong and inclusive growth. Durable deficit cuts would put public finances on a sustainable footing. Continued strong oversight of the financial sector and close cross-border supervisory cooperation would maintain financial stability.

• Continuing a reduction of the fiscal deficit to ensure debt sustainability: Stabilizing the debt-to-GDP ratio at a moderate level of 40 percent of GDP would leave room for the expected increase in ageing-related costs and other priority spending. Since the room for additional spending cuts is limited in the short run, the government’s plan to focus on revenue measures is appropriate.

• Allowing automatic stabilizers to work fully: If growth turns out lower than expected, policymakers should allow automatic stabilizers to operate (for example, through higher unemployment compensation and social assistance), thereby limiting the effects on the economy.

• Improving expenditure efficiency and tax administration: Reforms targeted at greater private sector participation in health care and strengthening value-added tax administration—aided by the planned unification of revenue collections—could generate some 3 percent of GDP in additional budgetary savings. The government could use the generated savings to further reduce debt, to improve public sector outcomes, and to finance public infrastructure in less developed regions of the country.

• Continuing supervisory vigilance: Close cooperation with home supervisors is essential to mitigate cross-border risks. Subjecting all types of housing loans to the same regulatory requirements would help prevent excessive risk taking. Removing tax obstacles—such as allowing loan losses to be tax deductible in the year they were incurred—would expedite the resolution of nonperforming loans and support a healthy expansion of credit.

• Boosting employment: Reducing the unemployment rate—currently in double digits—remains a top priority. In this regard, better-targeted vocational training programs would reduce skill mismatches. Also, further tailoring university education to job market needs would spur innovation and increase productivity.

• Addressing regional economic imbalances: The eastern regions of the country remain less developed than the western parts. The planned policies to expand and improve infrastructure, increase employment incentives, and address housing shortages that inhibit mobility are therefore welcome.

• Stepping up efforts to improve the business climate: This can be done by addressing lingering corruption and weak property and contract rights.

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